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April 25, 2011

Politics, the Treasury and Risk

Should Congress take a lesson from investors on mitigating risk through diversification of asset classes and styles?

The political process in the U.S. is a messy business once you delve deeper than Capitol Hill horse trading, party affinity, or the pro-business or pro-consumer view. It isn’t hard to see the influence of colossal amounts of lobbying and campaign money on those who are supposed to represent all of us. Still, there are things that make me wonder.

After all we have seen this last 12 months, with credit downgrades to the sovereign debt of Greece, Ireland and Portugal, among others, it is astounding that there are those who really don’t seem to understand what happens when countries’ debt ratings go negative or are lowered.

That U.S. politicians have not been wiser when it comes to brinksmanship in refusing to raise America’s debt ceiling, risking a lowered credit rating on U.S. sovereign debt is just baffling. We got the smallest taste of the potential impact when, last week, S&P said that it had changed its view of the creditworthiness of the United States to “negative,” even though it had affirmed the actual rating.

Any doubt of the obligation of the United States to repay its debt—the place where the world invests when a flight to quality is necessary—used to be beyond imagination. When I traded these securities, or recommended them to clients, there really was nothing safer. Trillions of dollars in U.S. debt is owned by investors large and small around the world.

What if U.S. Treasury Debt Was Downgraded?

This debt must remain sacrosanct, beyond reproach, for what would be the world’s safe haven in the worst of times if the debt of the United States, backed by the full faith and taxing power of the United States of America should be downgraded—or allowed to default?

Wouldn’t the increased interest rates demanded by the markets make it more expensive to sell Treasury debt? You bet. Wouldn’t that require an increase in taxes to pay off more costly debt? The plain truth is, if politicians want to lower taxes, threatening to default on America’s obligations by allowing the country to hit the debt ceiling—or threatening to—is not the way to accomplish that. It can only hurt the country by eroding confidence and raising the risk of investing in U.S. Treasury debt—thereby increasing costs, not decreasing them.

Mitigating Risk

These are, of course, not the only risks investors face, and veteran analyst and investor A. Michael Lipper treats us to his thinking on several types of risk for equities investors in his recent blog post, “Identify Your Strategic Risk Points.” He is president of Lipper Advisory Services, Inc. and created the Lipper Indexes and Averages for mutual funds. He is the author of “MONEY WISE: How to Create, Grow and Preserve Your Wealth" (2008, St. Martin's Press).

Lipper notes some of the lessons investors can learn from considering the momentum, value and sports handicapping approaches to investing and that a balanced approach to growth versus value—and not traveling with the institutional herd—may be a better way to mitigate some of the risks inherent in each.

This reasoning made me wonder if a more moderate approach to cutting the deficit and taxes might be possible in Washington. Certainly, if one thinks that the best way to invest is to prudently diversify the risk across asset classes and styles, with the goal of reducing risk while at the same time boosting returns, perhaps a more moderate, less partisan Congress could find a way to cut the deficit and taxes in a more diverse and moderate fashion and over a longer period of time, mitigating the risks to the fragile U.S. and global economy. Preserving the credit rating of the United States is not to be taken lightly; the wellbeing of Americans depends on it.

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